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Friday, June 17, 2011

Caballero #1: Demand for Safe Assets in the Financial Crisis

The Minneapolis Fed publishes a magazine called the Region that has consistently excellent interviews with leading economists. The June 2011 issue has an interview with Ricardo Caballero, who is chairman of the MIT economics department. To avoid making this post of encyclopedic length, I'm going to break it into three parts: Caballero on the demand for safe assets in the financial crisis, on moral hazard concerns during a financial crisis, and on how to do macroeconomics these days. But the excerpts in these three posts just scratch the surface of the interview, and the whole thing is worth reading.

Here's Caballero on what he sees as the underlying root of the financial crisis: a global shortage of financial assets, and especially highly-rated fixed income assets. In describing the financial crises, he says:

"It’s a story in two steps. The first, present at least since the Asian crisis, is that the world has experienced a shortage of assets to store value. Emerging and commodity-producing economies have added an enormous demand for assets that is not being met by their limited ability to produce these assets. I believe this global asset shortage is one of the main forces behind the so-called global imbalances, the low equilibrium real interest rates that preceded the crisis, and the recurrent emergence of bubbles. Contrary to the conventional wisdom, I think these phenomena are not the result of loose monetary policy, but rather the other way around: Monetary policy is loose because an asset shortage environment would otherwise trigger strong deflationary forces. ...

"This is the second step, which began in earnest after the Nasdaq crash, when foreign demand for U.S. assets went back to its historical pattern of being heavily concentrated on fixed income ... and especially on highly rated instruments. ...The enormous demand for U.S. assets, with a heavy bias toward “AAA” instruments, could not be satisfied by U.S. Treasuries and single-name corporate bonds, and that imbalance generated huge incentives for the U.S. financial system to produce more “AAA” assets. As a result, we saw both the good and the bad sides of the most dynamic financial system in the world, in full force. Subprime loans became inputs into financial vehicles, which by the law of large numbersand by the principles of tranchingwere able to create "AAA" instruments from those that were not. ...

"Unfortunately, by construction, AAA tranches generated from lower-quality assets are fragile with respect to macroeconomic and systemic shocks, when the law of large numbers doesn’t work. That is, this way of creating safe assets may be able to create micro-AAA assets but not macro-AAA assets. In other words, these assets were not very resilient to macroeconomic shocks, even though they might have technically met AAA risk standards. ...

"In principle, this was not a big issue, but it became a huge one when highly leveraged systemically important institutions began to keep these macro-fragile instruments in their balance sheets (directly, or indirectly through special-purpose vehicles, or SPVs This was an accident waiting to happen; AIG and the investment banks should have known better, but the low capital charges were too hard to resist."